Seven Themes For 2010

1. Buy SOE (State Owned Enterprises) Banks: The Central Bank is likely to start raising rates in January 2010. Rising rates favor Indian banks as they run a maturity mismatch on their balance sheets (liabilities have a longer maturity). Thus NIMs will rise; coupled with acceleration in loan growth (which trails IIP growth), this will help earnings. The stocks of SOE banks trade at better valuations than their private sector counterparts and SOE banks will also be helped by a declining fiscal deficit, which will likely cap long bond yields.

2. Avoid Technology: Tightening by the Central Bank will put upward pressure on the rupee with negative consequences for technology stocks. Tech stocks have done particularly well over the past six months and also suffer on a relative basis in an accelerating domestic growth environment. Tech stocks correlate negatively with INR.

3. Buy Energy: Energy, especially Reliance Industries, has delivered its worst relative performance ever on a trailing-six-months basis. The sector correlates positively with crude oil, short-term yields (read: local inflation) and industrial production. Thus it provides a hedge against a spike up in crude oil prices.

4. Buy Industrials: Acceleration in industrial growth will help close the output gap faster than what is possibly in the price right now. This will help a new private capex cycle to start in 2010 and further boost performance of industrials.

5. Shift Bias From Rural to Urban Plays: No doubt rural growth remains very strong, helped by rising food prices and government spending. Yet at the margin, urban growth will close the gap vs. rural growth as industrial activity picks up. Two-wheeler and large cap staple stocks tend to correlate negatively with industrial growth and should be avoided in 2010. In contrast, media and niche mid-cap staples may still perform well.

6. Buy Mid-caps: The broader market is likely to generate faster earnings growth of around 25% in 2010, trades at better valuations than the narrow market, and accordingly could outperform the narrow market.

7. Stock Picking Could be in Vogue in 2010, Market to be Driven by Earnings: A high market effect, high sector correlation and middling micro factors such as valuation, fundamental and return dispersion sets us up for a better stock picking environment in 2010. Most of the market returns in 2009 have come from a PE re-rating, and as the key driver of returns shifts to earnings in 2010, so will the key driver of stock prices from macro to idiosyncratic stock related factors.